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Everybody makes mistakes investing, no matter how much experience you have. But there are certain common mistakes that beginners make that don't seem like mistakes at first. Here are just three of them.
Not everything you buy goes up immediately.
But while the reluctance to take a loss is common to everyone, the desire to narrow the unrealized loss by "averaging down" is a beginner's ploy.
Averaging down is the purchase of more stock, at a lower price, with the idea of having a lower average cost for the entire lot.
There is nothing wrong with buying more shares in a long-term investment, when the price declines. After all, if it was a good investment at a higher price, it should only be a better investment at a lower price, right?
But we've noticed that some investors average down, not to reap higher gains, but to lower the "breakeven point." Something about a lower breakeven point gives them comfort, regardless of the fact that more money is now exposed to loss.
If you have ever averaged down, ask yourself the following questions.
Do you find yourself making calculations of a new breakeven point after you make an "average down" purchase? Do you focus on that new price point as a "target" for the stock? Do you think that reaching that price point will give you a greater sense of comfort?
If you do, these are tell-tale signs that you are acting out of emotion, rather than a reasoned premise for investing. After all, if your original premise, that the company is going to grow and therefore the stock will rise, is right, then your vision is for a stock price much higher than the current price. Until your faith in the future of the company is shaken, it shouldn't bother you that the stock is down. After all, it's only momentary.
If you don't believe that, you don't really have an investing premise. If you need to average down to give yourself a greater comfort level that the breakeven point is closer, you should also realize you are adding a huge level of risk to your position. And if you don't have a solid investment premise, what good is more risk?
On an investing premise where your expectations are that the stock will eventually double or more as it fulfills its growth prospects, what difference does it make if your entry point is 1/8 point higher or lower? Particularly on a $50 stock.
Yet, investors frequently try to shave their entry point by tiny fractions of the price. Using limit orders placed just below the current spread, they hope to catch an entry point below the current market price.
We've even seen investors issuing orders all day long, trying to save just 1/16 of a point (a "teenie").
To do this for an investment premise is just plain foolish. Especially if you wind up missing the beginning of a move.
Suddenly, two hours later, after your limit hasn't been filled, the stock is $2 higher, and isn't looking back. Now it definitely costs more to enter, especially if you wanted 2,000 shares. What good was trying to save $200?
This happens often. The solution is to remind yourself that your investment premise is a doubling or tripling of the stock. Once you've found a good long-term investment, it is more important to build your position than to shave a 1/16 of a point on the trade.
If you really want to enter a long-term position, but not get taken on the price, enter a limit price halfway between the current spread. It will get executed, unless your order is way over the average order size.
Of course, for a trading premise, the above advice is completely meaningless. Make sure you know the difference.
The old phrase is "a watched pot never boils."
But when you buy a hot stock on a trading premise, and then don't watch the pot, it is more likely that the pot will boil over on you.
Surprisingly, this happens all the time.
Investors buy a stock on a tip, on a message board notice, on a news article, or on a TV spot. Often, the stock has already begun its move, on sharply higher price and/or volume. In fact, the TV spot or news article may be about the stock's sharp run.
So the eager investor buys in. And then goes about trying to learn more about the stock.
For an investment, this is exactly the wrong way to buy a stock.
For a trade, jumping in on a hot stock on a momentum premise, is perfectly legitimate. But it requires careful timing of the exit. The proper exit may be a half-hour later, or it may be three weeks later.
But a good trader has a defined vision of when to make an exit. And all too often, that time to exit arrives before the after-purchase-researching has been completed by the investor.
This leaves the "hot stock" investor, who thought he/she had found a good thing, wondering what the heck happened, when the volume dries up, and the stock is off 30%.
How to avoid this problem? Quite simply, be very clear whether you are making an investment or a trade.
If you are making an investment, do the research first. Otherwise, it isn't an investment. If the stock gets away from you during that time, don't kick yourself. You didn't make a mistake. It happens.
If you are making a trade, forget the story behind the stock and watch the charts. The story is only what started the run. Use charts, technical analysis, or some other system to plan your exit.
But whatever you do, don't jump into hot momentum stocks, with tens of thousand of dollars, and then try to figure out what the long-term prospects of the company are. This mistake is all too common and can be very costly.
Averaging down solely to comfort yourself.
Trying to save a small fraction on a long-term investment.
Buying long-term before researching.
Everybody has done all of these in the early parts of their careers. But if you are going to stick around the market for a long time, you need to realize that all three are mistakes.
Robert V. Green